Category Pharmacy Benefit Managers

Who is Best at Negotiating Pharmaceutical Rebates?

Posted on my blog as .pdf on 12-1-2005

The roll out of the new Medicare drug benefit program has renewed the debate about who is best at negotiating drug rebates with pharmaceutical manufacturers (“Pharma”).  Those who favor the Federal government point to statistics showing that Medicaid gets significantly better rebates than private sector entities called pharmacy benefit managers (“PBMs”).  

The purpose of this paper is to provide new insights into this question by viewing pharmaceutical rebates through bargaining theory. The first insight is that rebates are paid selectively so that averages of rebate rates across all brands are a poor measure of negotiating power.  PBMs’ ability to extract rebates from Pharma is much greater than previously realized when rebate averages are disaggregated.

The second insight derived from bargaining theory is that the rebate transaction is much more complex than the price theory conceptualization of rebates as volume discounts. Drug rebates are tariffs, or entrance fees, paid by Pharma to gatekeepers who promise access to markets with reduced competition.

Medicaid gets more than PBMs, but gives up more in terms of rights to impose co-payments, “prior authorization” restrictions and rights to switch on-patent brand prescriptions to lower cost therapeutic equivalents.  PBMs receive less than Medicaid, but they give up less. Based on the overall goal of cost containment, there is evidence that private sector PBMs do a better job at rebate negotiation than Medicaid.

The Variability of Pharmaceutical Rebates

Two recent studies provide new data on the variability of pharmaceutical rebates rates.  Disaggregating this data by classes of drugs demonstrates the weakness of using broad averages to measure rebate-negotiating power.  A recent letter from the Congressional Budget Office (CBO) provided an unprecedented breakdown of the often-quoted nineteen percent average rebate rate that Medicaid receives from Pharma.   

The Medicaid deal is as follows: in return for being placed on the Medicaid formulary and sheltered from prescription switching and other restrictions, a drug’s manufacturer must rebate the government the greater of 15.1 percent of its average manufacturer’s price (AMP) or the difference between the “best price” given to a private sector reseller and the 15.1 percent minimum.  

The CBO letter revealed that thirty-six percent of Medicaid brand drug spend received a “best price” rebate while sixty-four percent of brand drug spend received the minimum.  In addition, the CBO letter provided evidence of the value of a little known clause in the Medicaid deal that gave the government inflation protection.  The value of that clause amounted to a surprisingly large additional rebate of 11.7 percent of AMP in 2003.   

Based on the above data, it is possible to disaggregate the 19.6 percent basic Medicaid average into a 27.6 percent average paid on “best price” drugs and the 15.1 percent minimum paid on the rest.

In September of 2005, the Federal Trade Commission (FTC) released a long awaited study of potential conflicts of interest by independent PBMs.   The FTC obtained data on rebate receipts by drug for the “Big Three” independent PBMs—Caremark Rx, Medco Health Solutions, and Express Scripts. These three large PBMs manage about sixty percent of all outpatient prescriptions in the United States.

The FTC study confirmed that Pharma pays rebates only on a small portion of brand drugs. It does not pay on brand drugs with a monopoly position.  Nor does Pharma pay on brand drugs in aging therapeutic classes where most of the competing brands have lost patent protection.

The FTC also confirmed that Pharma negotiates brand rebate deals only with PBMs, and not retail drugstore chains like Walgreen and CVS. Size does not matter on the buy-side if an entity does not also have the power to affect the demand for brand drugs through discretion in formulary design and compliance.

On the other hand, it is generic drug manufacturers that negotiate volume discount deals with drugstores because only dispensing pharmacies have the power to choose from an array of suppliers of perfect substitutes.  

Unfortunately, the FTC failed, or was prohibited, from disclosing any detail about rebates rates by drug or therapeutic class.  However, it is possible to perform a rough disaggregation of the disclosure that the Big Three PBMs received an average of  $6.34 in rebates and data fees per on-patent drug in 2003.  

The FTC disclosed that data collection fees paid by Pharma amounted to three percent of wholesale acquisition costs.  Subtracting out these substantial fees, that some allege are masked rebates exempt from inclusion in Medicaid “best price” calculations, the estimate for the average rebate received per brand is $4.22.

The key to disaggregating this average was another disclosure that seventy-one percent of rebate receipts for each PBM were concentrated in the top twenty-five rebate receiving drugs.  Assuming that these highly rebatable brands represent about twenty percent of brand drug prescription volume, it is possible to decompose the $4.22 broad average into rebate components of $14.98 for the top rebate-receiving drugs and $1.53 for the rest.
For comparison purposes, Table 1 presents the conversion of rebate levels to rebate rates based on an assumed average wholesale cost (WAC) or AMP.  While the Big Three PBMs received on average 8.0 percent of AMP across all brands, they receive 22.7 percent of AMP on rebatable drugs.  This is comparable to the 27.6 percent that Medicaid receives as a “best price” rebate. Not too much should be made of differences as the ratio is sensitive to an assumed average for WAC and AMP.  


Overall, Medicaid receives more, but this is mostly due to the inflation factor and government’s unique ability to confiscate a 15.1 percent minimum from the all powerful (monopolists) and the all powerless (many competitors).

Disaggregation presents a completely different perspective on the rebate negotiation ability of the Big Three PBMs.   This ability is not something that they care to make transparent for strategic reasons. They also show no inclination to challenge the validity of using broad averages as measures of rebate negotiating ability.

There is much speculation over who actually triggers the Medicaid “best price”.  Some believe that the Big Three PBMs get the “best price” based on their sheer size and a business model bias that favors abstaining from switching of a rebatable brand drug to lower cost generic that garners no rebates.  

Others believe that HMOs with captive PBMs, like Kaiser Permanente, trigger the “best price”.  These HMOs know that their members are willing to sacrifice some freedom of choice for competitive premiums.  HMOs with captive PBM operations garner rebates through formulary design and compliance that advantages a single drug in a therapeutic class.

In contrast, the Big 3 PBMs tend not to play favorites, but extract rebates from competing manufacturers by promising each that they will abstain from disadvantageous restrictions and prescription switching.  This passivity allows other forms of competition like advertising and physician “detailing” to take over.

The Pharmaceutical Rebate Bargain

Price theory has been misapplied to the case of pharmaceutical rebates.  Rebates are not volume discounts.  They are not evidence of price discrimination based on elasticity of demand.  It may be incorrect to apply the analysis of “most favored nation” clauses to the Medicaid “best price” formula.

 Rebates are the result of a bargain over the surplus that is created in a market characterized by a bilateral oligopoly. Secrecy and credible threats are central to the negotiation of pharmaceutical rebates.  

There are several fundamental insights gained by viewing pharmaceutical rebates through bargaining theory.

First, the welfare implications of this deal are complex.  PBMs may not be the populist countervailing force conceptualized by John Kenneth Galbraith.  PBMs may be enabling and codependent, rather than countervailing.

The surplus that is being divided up here is not necessarily fixed.  It is possible that Pharma and PBMs are tacitly colluding to increase the surplus in an intermediate market at the expense of excluded competitors on the sell side and powerless downstream consumers on the buy side.    Evidence that PBMs and the government extract substantial rebates from Pharma is not sufficient proof that their actions improve consumer welfare.

Second, there are two sides to the rebate deal.  The question of who is the best rebate negotiator involves an evaluation of what is received relative to what is given up.  Private sector PBMs receive less than Medicaid, but they give up less in terms of rights to engage in therapeutic interchange, impose usage restrictions, and affect demand through co-payment differentials.

When the Medicaid deal was struck in 1990, generic drugs were not the competitive threat that they are today. In return for rebates, the government promised to place a brand drug on the Medicaid formulary and exempt it from any prescription switching and usage restrictions such “prior authorization”. In 1993, the deal was modified so that generic substitution—an off-patent brand switched to a generic equivalent—was allowed.  

 Companies paying Medicaid for formulary placement today are still protected from any type of therapeutic interchange—an on-patent brand switched to less costly generic that is a therapeutic equivalent. In addition,  “prior authorization” restrictions cannot be imposed at the national level, but remain a local option that several states have seized as a bargaining chip to extract supplemental rebates from Pharma.

A recent study by the Lewin Group evaluated the performance of different Medicaid plan managers on the basis of overall drug spend delivered, and not narrowly on net unit prices after rebates.

One set of plans—known as Medicaid fee-for-service (FFS)—are eligible for “best price” rebates, but must adhere to Medicaid guidelines limiting therapeutic interchange and usage restriction.  The other set of plans—known as Medicaid managed care organization (MCO)—are privately managed by PBMs and not eligible for Medicaid rebates. However, these PBMs have a lot more discretion in formulary design and compliance.

The Lewin Group study found that Medicaid FFS plans received rebates averaging fifteen percentage points higher than Medicaid MCO plans.  However, the discretion allowed by PBMs who managed Medicaid MCO plans enabled them to deliver a fifty-nine percent generic dispensing rate—the number of generic prescriptions divided by the sum of all prescriptions —compared to a fifty percent rate found for Medicaid FFS plans.

 Even more dramatic was difference in usage rates—number of prescriptions per member per month.  PBMs were able to deliver a usage rate that was fifteen to twenty percentage points lower than Medicaid FFS plans.   

Overall, the drug spend of privately managed plans was ten to fifteen percentage points lower than government run plans despite lagging in rebates received from Pharma.  

The results of this study clearly demonstrate the weakness of evaluating bargaining agents solely on the basis of rebate rates.  Based on overall goal of cost containment, this study provides evidence that private sector PBMs do a better job at rebate negotiation than Medicaid.

References and Further Reading

Beronja, Nancy et. al. 2003. Comparison of Medicaid Pharmacy Cost and Usage between Fee-for-Service and Capitated Settings.  Resource Paper prepared by the Lewin Group for the Center for Health Care Strategies, Inc.

Congressional Budget Office. 2005. The Rebate Medicaid Receives on Brand-Name Prescription Drugs.  Attachment to letter to Senator Charles Grassley dated June 22, 2005.

Federal Trade Commission. 2005. Pharmacy Benefit Managers: Ownership of Mail-Order Pharmacies.

Written: 12-1-2005

© Lawrence W. Abrams, 2005

Disclosures: I have not received any remuneration for this paper nor have I financial interest in any company cited in this working paper. I have a Ph.D. in Economics from Washington University in St. Louis and a B.A. in Economics from Amherst College. Other working papers on PBMs can be accessed at

Prop 61: Which Tony Soprano Bargaining Agent Do You Want?


Summary:   A YES vote  is a vote for an honest, but a narrow-minded Tony Soprano style of bargaining. A NO vote is for a dishonest, but open-minded Tony Soprano style bargaining.

California Proposition 61 — a.k.a. The Drug Price Initiative  —  forces managers of  government employee prescription drug plans to get more rebates from drug manufacturers.   YES ads feature Bernie Sanders and his anti-big business mantra.  NO ads feature Veterans lamenting the possibility that this measure will increase their prescription drug costs.

No one has analyzed this proposition starting with the idea that there are two sides to any deal.  You have to ask the question:  Rebates in return for what?

You have to start with bargaining styles to understand the problem Proposition 61 seeks to fix.    Lowering prescription drug prices is all about changing the bargaining style of plan managers.  

A YES vote says you want the style used by the Veterans Administration (VA).  A NO vote say you want to maintain the status quo and keep the bargaining style used by contracted pharmacy benefits managers (PBMs) such as CVS Caremark, UnitedHealthcare’s OptumRx, and Express Scripts.

To better understand the implications of California Proposition 61, we need only look to the pilot episode of the HBO hit series The Sopranos.   In that episode, Tony complains to his therapist Dr. Melfi about the stresses of being a “waste management consultant.”  

His job, for which he and his supporting crew are paid handsomely,  is to manage the competing interests of various sanitation companies wishing to win lucrative garbage contracts put out to bid by suburban New Jersey municipalities.

Tony has no real insights into the complexities of bid submission.  Tony’s sells himself as an effective gatekeeper, creating value by limiting access to lucrative markets.  He collects a tariff from those whom are allowed in and sends his nephew Christopher to exclude the rest.  

No wonder Tony is stressed.  Sanitation companies put Tony in a schizophrenic double bind “damn if you do, damn if you don’t” situation.  If Tony does limit competition to a single sanitation company, the favored earns excess profits while the excluded curse Tony.   If Tony does nothing, all the sanitation companies bid so aggressively against each other that no one profits and they all curse Tony.  Either way, someone is cursing Tony.

The Tony Sopranos of Prop 61 are VA administrators and PBMs.  These gatekeepers receive rebates from drug manufacturers in return for insuring limited competition from other patented brand drugs that are “therapeutic equivalents.”  

For example, there is fierce competition today among manufacturers of patented, but substitutable, combo drug therapies used to treat the Hepatitis C virus.  This includes pills from AbbieVie (Viekira Pak and Technivie),  Merck (Zepatier). and the more expensive, but more effective, treatments from Gilead Sciences (Solvadi and Harvoni).

Indeed, Harvoni is one of the most expensive drug therapies in the world with the list price of each pill at $1,125 and a total list price of $84,000 for a 12 week cure.

Plan administrators are able to slice off an estimated 30% to 60% of the list price in form of rebates in cases where there is competition among a few patented, but substitutable, brand drugs.

Indeed, over the past few years, a vicious cycle has emerged: drug  manufacturers raise list prices 15%, PBMs raise rebates demands 10%. Next year there is 20% increase in list prices coupled with a 15% raise in rebate demands, etc.   It is not clear who initiates and who responds here.  The villains might not be CEOs of drug companies like smirk-faced Martin Shkreli, but rebate-hungry CEOs of pharmacy benefit managers.

Prop 61 is about what version of Tony Soprano you want as a bargaining agent.

The vehicle for limiting competition is a list of drugs covered by the plan called a formulary.  The VA formulary is severely limited in terms of total drugs, but there are no copay tiers.  This highly restrictive formulary allows the VA to collect the largest rebates and the lowest net drug prices of any plan in the United States.

The PBM formulary lists many more drugs overall, but exerts secondary power over demand via copayment tiers, step therapy, and prior authorization.

Make no mistake.  Drug rebates are not volume-related price discounts.   If this were the case, then Medicare Part D drug plans with total enrollment of 70 Million enrollees would get higher rebates than the VA drug plan with 9 Million total enrollees.

The VA has a transparent business model.  VA employees earn a salary and only seek rebates in order to lower government costs.  But, unfortunately, the federal government historically has underfunded the VA.  Over the years, VA thinking has become narrowly focused on costs at the expense of quality of care for Veterans.  

A YES vote on Prop 61 is a vote for an honest, but a narrow-minded Tony Soprano seeking rebates for rebates sake,  with not enough weight given to consumer choice and quality of care.

A NO vote is for a secretive Tony Soprano pocketing rebates on the sly, but willing to pay higher prices for newer, more effective prescription drugs.  

We have no strong conviction either way.  

A YES vote is not good for Vets in the short run.  It will link California plans to VA prices and provide a disincentive for drug manufacturers to give big discounts to the VA.  But, ironically, a YES vote might be good for the Vets in the long run as it will call attention to the narrow-mindedness of VA administrators and force them to cover higher cost drugs that deliver better quality of care for Vets.

Our concern with Prop 61 is that it is tries to fix a problem by legislating outcomes rather than by legislating practices.  A YES vote legislates an outcome without any limits placed on the practices used to achieve mandated results. A NO vote preserves the status quo of PBMs as managers of state government employee drug plans.

We would have preferred that Proposition 61 mandate changes in the business model of any PBM that manages a state employee drug benefit plan.  This would include mandating a transparent fee-for-service business model with 100% pass-through of rebates  and no opaque “spread-margins”  earned on the resale of mail order generics.  

It would also mandate that enrollees have the option of obtaining 90-day prescriptions at local pharmacies as well as PBM-owned mail order operations.  Finally,  it would include outside review of PBM formulary choices.


Lawrence W. Abrams, Ph.D. has written over 20 papers on pharmacy benefit managers freely available at  He lives in N. Monterey County, California and can be contacted at